Theory of Production and Cost

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Fixed and variable costs. The cost of these fixed factors are the firm's fixed costs. The firm's fixed costs do not vary with increases in the firm's output.

Theory of Production: Cost Theory | Intelligent Economist

The firm also employs a number of variable factors of production. The cost of these variable factors of production are the firm's variable costs. In order to increase output, the firm must increase the number of variable factors of production that it employs. Therefore, as firm output increases, the firm's variable costs must also increase.

Production Function in the Short Run

The firm's fixed and variable costs are reported in Table. Total and marginal costs. The firm's total cost of production is the sum of all its variable and fixed costs. The firm's marginal cost is the per unit change in total cost that results from a change in total product. The concepts of total and marginal cost are illustrated in Table. The sixth column of this table reports the firm's total costs, which are simply the sum of its variable and fixed costs.

The seventh column reports the marginal cost associated with different levels of output. Marginal cost and marginal product. The firm's marginal cost is related to its marginal product. If one calculates the change in total cost for each different level of total product reported and divides by the corresponding marginal product of labor reported, one arrives at the marginal cost figure. The marginal cost falls at first, then starts to rise. This behavior is a consequence of the relationship between marginal cost and marginal product and the law of diminishing returns.

As the marginal product of the variable input—labor— rises , the firm's total product incresses at a rate that is greater than the rate of new workers hired. Consequently, the firm's marginal costs will be decreasing. Eventually, however, by the law of diminishing returns, the marginal product of the variable factor will begin to decline; the firm's total product will increase at a rate less than the rate at which new workers are hired.

The result is that the firm's marginal costs will begin rising. Average variable, average fixed, and average total costs. The firm's variable, fixed, and total costs can all be calculated on an average or per unit basis. Table reports the average variable costs, average fixed costs , and average total costs for the numerical example of Table. Graphical depiction of costs. The variable, fixed, and total costs reported in Table are shown in Figure. The marginal cost reported in Table along with the average variable, average fixed, and average total costs reported in Table are shown in the graph in Figure b.

When costs are depicted graphically, they are referred to as cost curves. Initially, marginal product is rising — e. Marginal product then starts to fall. The 7 th worker supplies 26 units and the 8 th worker just 20 added units. At this point production demonstrates diminishing returns. Criticisms of the Law of Diminishing Returns How realistic is this assumption of diminishing returns? Surely ambitious and successful businesses will do their level best to avoid such a problem emerging?

It is now widely recognised that the effects of globalisation and the ability of trans-national businesses to source their inputs from more than one country and engage in transfers of business technology , makes diminishing returns less relevant Many businesses are multi-plant meaning that they operate factories in different locations — they can switch output to meet changing demand. Subscribe to email updates from tutor2u Economics Join s of fellow Economics teachers and students all getting the tutor2u Economics team's latest resources and support delivered fresh in their inbox every morning.

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